SECTION 2. BACKGROUND

.01 Section 103(a) provides, in general, that gross income does not include interest on any state or local bond. Section 103(b)(2) provides, however, that this exclusion from gross income does not apply to arbitrage bonds.

.02 Section 148(a)(1) provides, in general, that bonds of an issue are arbitrage bonds if any portion of the proceeds of the issue is ‘‘reasonably expected’’ on the issue date of the issue to be used directly or indirectly to acquire higher yielding investments. .03 Section 1.148–1(b) of the Income Tax Regulations provides that an issuer’s expectations or actions are reasonable only if a prudent person in the same circumstances as the issuer would have those same expectations or take those same actions, based on all the objective facts and circumstances. Section 1.148–1(b) also provides that factors relevant to a determination of reasonableness include the level of inquiry by the issuer into factual matters.

.04 Section 148(f) provides, in general, that bonds of an issue are arbitrage bonds unless the earnings from the investment of bond proceeds in excess of the yield on the issue are rebated to the United States. The rebate requirement of § 148(f) is generally not based on reasonable expectations.

.05 Section 1.148–6(c) provides that gross proceeds of an issue of bonds are not allocated to a payment for a nonpurpose investment in an amount greater than the fair market value of that investment on the purchase date. For this purpose only, the fair market value of a nonpurpose investment is adjusted to take into account qualified administrative costs allocable to that investment.

.06 Section 1.148–5(d)(6)(i) generally defines fair market value as the price at which a willing buyer would purchase from a willing seller in a bona fide, arm’s-length transaction. Fair market value generally is determined on the date on which a contract to purchase the nonpurpose investment becomes binding (that is, the trade date rather than the settlement date).

.07 Section 1.148–5(d)(6)(iii) provides that the purchase price of a guaranteed investment contract is treated as its fair market value on the purchase date if the issuer makes a bona fide solicitation for a guaranteed investment contract that meets the requirements of that section. The definition of guaranteed investment contract in § 1.148–1(b) generally does

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Treasury securities to protect the seller against any increase in interest rates between the sale date (trade date) and the issue date (settlement date).

.14 In these transactions, a substantial mark-up of the price of Treasury securities for the risk of nonsettlement is inappropriate for two reasons. First, the risk of nonsettlement is remote. In addition, the seller of the Treasury securities is in a position to benefit if interest rates fall. This potential for benefit should reduce the weight given to the potential for loss if rates should rise. In general, nonsettlement is not more likely when interest rates rise than when they fall.

.15 In other cases, issuers have entered into agreements to purchase open market Treasury securities to be deposited into an escrow to pay the refunded prior issue of bonds. On the same date, issuers have subscribed to purchase United States Treasury securities—State and Local Government Series (‘‘SLGS’’) from the United States Department of the Treasury, Bureau of Public Debt to pay the same refunded prior issue of bonds. In effect, this arrangement provides a call option on the open market Treasury securities to the seller of those securities.

.16 In the case of simultaneous SLGS subscription and forward purchase contracts, the issuer and the seller of the open market Treasury securities agree on the sale date that, if the advance refunding bonds are issued and if interest rates decline between the sale date and the issue date of the advance refunding bonds so that the value of the nonpurpose investments increases, the issuer will purchase the SLGS. In this case, the seller will not be obligated to deliver the open market Treasury securities to the issuer. Alternatively, if the advance refunding bonds are issued and if interest rates remain the same or increase between the sale date and the issue date so that the value of the nonpurpose investments remains the same or decreases, the issuer will be obligated to purchase the open market Treasury securities. In this case, the seller will be obligated to deliver the open market Treasury securities to the issuer for deposit into the advance refunding escrow. In addition, the issuer will not purchase the SLGS. In such a case, by subscribing for the SLGS, the issuer in effect provides a call option on the open market Treasury securities to the seller of the open market Treasury securities. For purposes of the arbitrage rules, the fair market value of the open

market Treasury securities under the agreement with the seller must accordingly be reduced by the value of this call option.

.17 Even if the issuer obtains certifications that the purchase price being paid for nonpurpose investments does not exceed the fair market value of those investments, an issue may nevertheless fail to meet the reasonable expectations standard of § 148(a). Further, in general, an agreement between unrelated persons about price does not presumptively establish fair market value in a situation where one party to the agreement lacks financial incentive to obtain the best price. See Raymond v. Commissioner, 114 F.2d 140 (7th Cir.), cert. denied, 311 U.S. 710 (1940).

.18 All the facts and circumstances are considered in the determination of whether the proceeds of the issue are to be invested at a materially higher yield. Factors strongly tending to establish that an issuer does not reasonably expect the proceeds of the issue to be invested at a materially higher yield are (1) the use of a bona fide bidding procedure to reasonably probe the market for the fair market value of nonpurpose investments and (2) reasonable due diligence by the issuer to review the method used to determine the fair market value of Treasury securities. One important factor tending to establish that a bidding procedure is bona fide is that it is conducted by a person that does not have a material financial interest in the transaction (for example, as the seller of Treasury securities to the issuer).

.19 Some issuers have obtained Treasury securities for an advance refunding escrow by using procedures that generally are designed to conform to the safe harbor for guaranteed investments contracts in § 1.148–5(d)(6)(iii). Although that safe harbor does not expressly apply to the purchase of Treasury securities for an advance refunding escrow, the Internal Revenue Service will apply the principles underlying that safe harbor to the purchase of those nonpurpose investments. Absent extraordinary circumstances, a bona fide bidding procedure consistent with the principles of the safe harbor for guaranteed investments contracts is rebuttably presumed to establish fair market value for transactions to which this revenue procedure is applicable, even in cases where the forward price paid for Treasury securities is greater than the spot price of those Treasury securities. Other procedures may also establish fair market value.

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.20 If promulgated as a final regulation, § 1.148–5(d)(6)(v) of the proposed Income Tax Regulations, published in the Federal Register on June 27, 1996 (61 Fed. Reg. 33405), would provide a rebuttable presumption for establishing fair market value for Treasury securities purchased other than directly from the United States Treasury for those transactions described in the regulation.